Part 1 explains the ins and outs of legally maximizing your owner's draw or salary, while not running afoul of the IRS or damaging your business's cash flow.How to get money out of your business...the entrepreneur's eternal quest! Since you're in business for yourself, you have choices: You can pay yourself what you always knew you were worth or you can plow most of your cash back into growing your business.
You may also partake of the tax advantages inherent in paying family members who are in lower brackets or grant yourself and your employees company benefits, such as a nice retirement plan or a company car.
Chances are you'll eventually do a little of each. Often it comes down to a decision as to what's more urgent, your needs or the needs of the business. You need to pay your mortgage and feed your kids, but the business may need to meet debt/equity ratios to pacify your bankers. How much personal luxury are you willing to forego or defer to achieve stability in your business?
There are an amazingly large number of legal, and even tax-advantaged, ways to take money out of your business. In this, the first of a two-part series, we'll examine the primary way to withdraw cash: your salary or owner's draw. In the second part we'll discuss some other ways to use your business to improve your lifestyle.
Your salary or owner's draw
The level of compensation you draw from your business will undoubtedly vary widely from time to time due to the ebb and flow of your personal and business needs. At least initially, don't plan on taking more out of the business than will cover your bare-bones needs for food, clothing and shelter. Better yet, try to keep an alternate source of income going to support yourself and your family until you can be sure that your business is financially viable. It's much more common for new business owners to underestimate their business's hunger for cash than to overestimate it.
Once your business is in the black, you can begin pulling some money out as compensation for all the hours of hard work you've contributed. If your business is structured as a sole proprietorship, you will pay yourself directly through an "owner's draw" and report this on Schedule C of your individual tax return. It's best to take your draw at regular intervals such as weekly or monthly, so that you can arrange to have adequate cash flow from the business to cover it.
If your business is organized as another type of "flow through" entity (such as a partnership, LLC or S corporation), your cash compensation level will be dictated more by the cash-flow characteristics of the operation than by tax law imperatives. Since you will be personally taxed on your portion of the profits of any non-C corporation business whether you draw a formal salary or not, it's a distinction without a difference.
Both an S corporation and a C corporation can be used to structure compensation in a way that avoids payroll taxes. If your income level is high enough, the tax savings on payroll taxes can be substantial. For example, John Edwards used an S corporation to as a channel for his law firm profits. By shrewdly characterizing the bulk of the profits as dividends, rather than salary, he managed to avoid paying over $750,000 in employment taxes.
Salary from a C corporation
From the owner's standpoint, the term "salary" really applies only to C corporations. (Of course, employees having no ownership interest are paid wages or a salary, regardless of the structure of the business.) While corporate profits are taxed twice, the corporation gets a business deduction for your salary.
Thus, a key determination in setting your salary is the difference between the corporation's and your personal tax rate. If your corporation's highest tax bracket is lower than your highest personal bracket, the tax benefit derived from the company's deduction of your compensation will be less than the tax you must pay on it as personal income. And if your company isn't turning a profit, there's no tax benefit at all. Conversely, if your corporate bracket is higher than what you think your personal tax rate will be for a certain year, you might consider increasing your compensation.
With a C corporation, it's usually a good idea to keep your compensation as regular and level as possible to avoid waving any red flags at the IRS. The major problem to avoid is having the IRS recharacterize some of your salary as disguised dividends, which are not deductible to the company. This becomes a danger if your salary grows beyond what is considered reasonable for your position.
The criteria for judging "reasonable compensation," as determined by years of IRS examination and litigation, include:
- The nature and size of the business claiming the deduction
- The nature and scope of the work you do for the business
- Any special qualifications you may have
- The availability of others to perform the same duties
- General economic conditions
- Compensation compared to business income and profits
- Compensation relative to dividends
- Compensation relative to other employees
- Compensation relative to stock ownership if the business is a corporation with more than one shareholder
- Your compensation history for past services
You should also be aware that for personal service corporations (PSCs), all profits are taxed at a flat rate of 35 percent. PSCs are defined as corporations performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, the performing arts or consulting, where substantially all of the stock is held by employees, retired employees or their estates. PSCs can generally pay out all or most of the corporation's profits as salary, since arguably all the company's profits are the result of the efforts of its owners.